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Unit 3: Exchange Rates. Crash Course in Money 3/19/2012. Origin of Money. Carl Menger is the father of the Austrian school of economics. He theorized that money came about through evolution from barter. Menger’s Origin of Money. Why do people trade useful goods and services - PowerPoint PPT Presentation
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Unit 3: Exchange Rates
Crash Course in Money3/19/2012
Origin of Money
Carl Menger is the father of theAustrian school of economics.
He theorized that money came aboutthrough evolution from barter.
Menger’s Origin of MoneyWhy do people trade
useful goods and servicesfor silly little pieces of paper?!
Menger’s Origin of MoneyBarter (Direct)
Medium of Exchange (Indirect)
Money (CAMOE)
Barter
barter (direct exchange) –trade for something that
can be used directlyin consumption or
production
Barter
Barter can work well when you easily find a parallel trader.
In that case not using money actually saves a step.
BarterBut often finding someone who has what you want and wants what you have is very difficult.
Search costs and other transaction costs can
be quite high.
Barter
double coincidence of wants –each person must want the good
his trading partner is offering
Barter
transaction costs –opportunity costs of finding a trading partner, negotiating a
deal, and monitoring the terms
Barter
Transaction costs of barter are so huge that it is very inefficient.
Barter only exists where laws or social norms make efficient indirect
trade difficult or impossible.
Barterplaces barter survives• to evade or reduce taxes• underground economy• marriage, dating, sex• new car (trade in old)• health/dental benefits (less taxes)
Indirect Exchange
medium of exchange(indirect exchange) –
something not wantedfor commodity value,
but rather for trade value
B > A > C B-owner refusesto trade for A.
C > B > A C-owner refusesto trade for B.
A > C > B A-owner refuses to trade for C.
A
B
C
Indirect Exchangetrader endowment preference trades ends with
A
B
C
Indirect Exchangetrader endowment preference trades ends with
B > A > C (1) A C (2) C B
C > B > A B C
A > C > B C A
(MOE)
Indirect Exchange
The trades worked because a medium of exchange was used.
Here broccoli was themedium of exchange.
But the medium of exchange could be anything. ?
(MOE)
Indirect Exchangedegree of marketability –
more highly marketable goodsare easier to sell for a “good price”(best price with full information)
In other words, more marketable goods have lower transaction costs;
more sellers will accept them.
Indirect Exchange
Marketability is anon-Walrasian concept.
In Walrasian economicseverything is always at equilibrium
(there are no transaction costs).
Indirect ExchangeTraders will begin to carry
an inventory of variousmedia of exchange.
Over time they notice somemedia of exchange are more
marketable than others.
Traders pick the more marketablemedium of exchange.
Indirect Exchangenetwork effect –
the value of a good increasesthe more people use it
Money has a network effect.
The more people use a mediumof exchange, the more marketable
that medium of exchange is,the more other people will adopt it.
Money
money –commonly acceptedmedium of exchange
Money
When a circulating medium of exchange becomes commonly
accepted (that is, widely adopted by most traders as the preferred media
of exchange), it becomes money.
Historical Monies
Many forms of commodity money have been adopted around the world.
The commodity chosen tends to be the main production good or ornamental.
Historical Monies
Colonial Virginia tobaccoWhere? What?
Historical Monies
West Indies sugarWhere? What?
Historical Monies
Abyssinia(Ethiopia)
saltWhere? What?
Historical Monies
Ancient Greece cattleWhere? What?
Historical Monies
Midieval Iceland woolWhere? What?
Historical Monies
Scotland nailsWhere? What?
Historical Monies
Ancient Egypt copper ringsWhere? What?
Historical Monies
Native Americans Wampum(beads on a string)
Where? What?
Historical Monies
Island of Yap(South Pacific)
Fei(large stone wheels)
Where? What?
Historical Monies
West Africa, China cowrie shellsWhere? What?
Historical Monies
Aztecs caoca beans(chocolate)
Where? What?
Historical Monies
China, Mongolia, Siberia teaWhere? What?
Historical Monies
Mesopotamia barley (grain)Where? What?
Historical Monies
Ancient Japan riceWhere? What?
Historical Monies
Colonial Australia rumWhere? What?
Historical Monies
prisons cigarettesWhere? What?
ConvergenceWhy did most civilizationsconverge to gold or silver?
Gold is more marketable due to several characteristics.
Characteristics• uniform• durable• divisible• portable• stable value
Convergence
uniform –purity can be tested at low cost(biting, sounding, or assaying)
Gold and silver are both pure elements on the Periodic Table.
assay – chemically testthe quality of metals
Convergence
durable –no extra carrying cost due to spoilage
Food commodities such asgrains and olive oil could spoil.Preventing spoilage had a cost.
Checking the quality of spoilable items during transactions had a cost
(see uniformity).
Convergence
divisible (and fusible) – payment canbe tailored to purchase size
Large pieces can beseparated into small pieces.
Small pieces can becombined into large pieces.
(Not true of livestock.)
Convergence
Convergence
portable –high ratios of value to bulk
In Sweden copper plate moneyweighed 44 pounds.
1 ship of gold = 15 ships of silver
Convergence
stable value –not subject to seasonal variations
Food commodities harvested acertain time of year could
experience large swings in pricedepending on the time of year.
durable (no spoilage)
portable (high value/bulk) divisible uniform (easy to grade) (coined) stable value (non-seasonal)
Silver oxen barley
Convergence
Convergence
When traders from two regionswith different commodity monies came into contact,
the better of the two moniesspread to the other region.
MengerianBarter (Direct)
Medium of Exchange (Indirect)
Money (CAMOE)
Neo-MengerianMoney
Gold & Silver
Coin
Bank Notes
Coins
Coins first appeared in ancient Lydia (Turkey) and China.
The earliest coins were punched,later coins were stamped,finally coins were minted.
Coinscoinage –
the process of fashioning monetary metal into standardized marked discs
Merchants had to assess weight and quality when receiving payment. They would mark a piece of assessed gold to avoid the cost of
re-assessing upon payout. Other traders would come to rely on the mark.
Coins
When metal commodity standard would replace another medium of exchange, often
the old medium of exchange would be stamped on the coin.
Here an ox head is stamped on a coin replacing a cattle commodity standard.
CoinsPrivate mints were common
around gold and silver mines.
Marketability of coins wasdiscontinuously greater than
marketability of unminted gold.
Marketability of money wasdiscontinuously greater thanthat of other commodities.
Coinsseigniorage –
profit that results from producing coins
(difference betweenface value and metal value)
Governments seized amonopoly on mints to reap
seigniorage income.
Coins
Justifications• seigniorage• propaganda• ending debasement
Government mint monopolieshad a number of publicinterest justifications.
Moneycommodity money –
money with a close relationship between money value and
commodity value
fiat money –money in which monetary
value far exceeds commodity value
Fiat Money
Typical path to fiat money1. government gives a monopoly on note issue to a single institution2. its liabilities become widely accepted3. government suspends redemption permanently
Ha Ha!
Fiat Money
“Over the years, all the governments in the world, having discovered that
gold is, like, rare, decided that it would be more convenient to back their money with something that is
easier to come by, namely: nothing.”– Dave Barry
Functions of MoneyMain function of money • medium of exchange
Subsidiary functions of money• medium of account• store of value• standard of deferred payment
unit of account –common numerator of all prices
More properly:medium of account –
good used as a pricing or accounting unit
unit of account –specific quantity of the
good used as a pricing or accounting unit
Functions of Money
Functions of Moneystore of value –
separates act of buying from selling(saving with low transaction costs)
standard of deferred payment –money is a good way of paying back loans
Monetary Aggregates
Money supply • MB – monetary base (total currency)• M1 – very liquid assets• M2 – somewhat liquid assets• M3 – even less liquid assets• MZM – money with zero maturity
Stock vs. Flowwealth is a stock value
(oz. Au)income is a flow value
(oz. Au / year)
Equation of ExchangeThe equation of exchange is the fundamental
mathematical idea of monetary theory.
MSV = Py
Definitionspurchasing power of money (PPM) –
the basket of goods and services that asingle dollar can buy (“price” of money)
price level (P) –weighted average of prices in the economy
PPM ≡ 1/PP
DefinitionsPrice level is stated in terms of price indexes.
Price indexes are inherently imprecise because you have to pick goods to include in the index and weight them.
There is no price index that includes everything.
Government price indexes• consumer price index (CPI)• producer price index (PPI)• GDP deflator
Definitionsinflation –
a rise in the price level (fall in PPM)
deflation –a fall in the price level (rise in PPM)
Definitions
relative prices –implicit barter ratios between goods
Price levels move independently of relative prices.
If the relative price of one thing goes up, logically the relative price of another thing must go down.
Definitionsreal variables – “constant” dollars
nominal variables – “current” dollars
Capital letter variables are nominal. Lowercase letter variables are real.
nominal/P = real
Y/P = y
Definitionsaggregate output –
total production of finalgoods and services in the economy
aggregate income –Total income of factors of production(land, labor, capital) in the economy
Usually they are equal(except in Balance of Payment analysis):y ≡ aggregate output = aggregate income
y
DefinitionsY ≡ nominal output
y ≡ real output
Y/P = yPy = Y
In the equation of exchange,we use a lowercase y (real output)
rather than capital Y (nominal output).
y
Definitions
MS ≡ money supply
The money supply can bein terms of any of themonetary aggregates:
M1, M2, M3, MB, MZM.MS
DefinitionsMS/P ≡ real money stock
real money balance –quantity of money in real terms
Real money balance is an important concept in the
Keynesian money demandtheory and in seigniorage.
MS/P
Definitionsvelocity of money (V) –
average number of times a unit of money turns over in a given period
Velocity is defined as total spending divided by the quantity of money:
V ≡ Py/MS
So the equation of exchange is an identity: MSV = Py
V
Equation of Exchange
MSV = PyImportant notes• an identity, not a theory (V ≡ Py/MS)• right side is nominal output (Y = Py)• MS can be any monetary aggregate (changing the aggregate changes V)
Quantity Theory of MoneyThe quantity theory of money conceived by Irving
Fisher makes two important assumptions.
Assumptions1. velocity is constant2. wages and prices are completely flexible
V
Quantity Theory of MoneyIf velocity is constant`V then ΔMS → ΔPy
(doubling MS will double Py).`VMS = Py
If P is completely flexible and y is sticky,assume`y: ΔMS → ΔP
(doubling MS will double P).`VMS = `yP
Graphical VersionThe graphical version uses the money demand equation
and the money supply equation to find equilibrium.
Money demand:MD = Py/V
Money supply:MS = C
(C is a constant)
Graphical VersionMD = Py/VMS = C
MD
MS
PPM(1/P)
M
Graphical VersionMS↑ → PPM↓ →P↑
increasing themoney supply
shifts the MS curve outmove along MD
PPM goes downP = 1/PPMP goes up
MD
MS
PPM(1/P)
M
MS'
PPM1
PPM2
Graphical Version
MS↑ → PPM↓ →P↑
matches the math:MSV = Py
`V(MS↑) = `y(P↑)MD
MS
PPM(1/P)
M
MS'
PPM1
PPM2
Graphical VersionV↓ → MD↑
→ PPM↑ → P↓
decreasing velocityshifts the MD curve out
move along MS
PPM goes upP = 1/PPM
P goes down
PPM(1/P)
PPM1
PPM2
MD'
MS
M
MD
MD = Py/V
Graphical VersionV↓ → MD↑
→ PPM↑ → P↓
matches the math:MSV = Py
`MS(V↓) =`y(P↓)
PPM(1/P)
PPM1
PPM2
MD'
MS
M
MD
MD = Py/V
Graphical Versiony↑ → MD↑
→ PPM↑ → P↓
increasing real outputshifts the MD curve out
move along MS
PPM goes upP = 1/PPM
P goes down
PPM(1/P)
PPM1
PPM2
MD'
MS
M
MD
MD = Py/V
Graphical Versiony↑ → MD↑
→ PPM↑ → P↓
matches the math:MSV = Py
`MS`V = (y↑)(P↓)
PPM(1/P)
PPM1
PPM2
MD'
MS
M
MD
MD = Py/V
Graphical VersionImportant insight
If something doesn’t affect MS or MD, then
it can’t effect the price level.
MDV = PyMS = C
MD
MS
PPM(1/P)
M
Graphical Version
The real money stock is the area of the
rectangle.
MS/P = (MS)(1/P)= (MS)(PPM)
MD
MS
PPM(1/P)
M
MS/Preal money stock
But empirical evidence shows that velocity is not a constant.
Velocity declines during severe economy contractions.
Even in the short run velocity fluctuates too much to be viewed as constant.
This paved the way for a new theory.
VLiquidity Preference Theory
John Maynard Keynes,the father of macroeconomics, wrote The General Theory of Employment,
Interest, and Money in 1936.His theory of demand for money, which
he called the liquidity preference theory, explored the question
“Why do individuals hold money?”
Liquidity Preference Theory
Liquidity Preference TheoryKeynes’ reasons individuals hold money• transactions motive• precautionary motive• speculative motive
Liquidity Preference Theorytransactions motive –
money is a medium of exchangethat can be used to carry out
everyday transactions
Keynes believed transactionswere proportional to income.
Thus the transactions componentof MD depends entirely on y.
Liquidity Preference Theoryprecautionary motive –
people hold money as a cushion against an unexpected purchase need
Keynes thought precautionary balances were based on future transactions, and
thus were proportional to income.Thus the precautionary component
of MD depends entirely on y.
Liquidity Preference Theoryspeculative motive –
people hold money as analternative store of wealth to bonds
Keynes thought people would switch from bonds to money when they believed bond values would fall.Thus the speculative component
of MD depends on the interest rate.
Liquidity Preference TheoryKeynes thought interest rates should be in a narrow band. When interest rates
are higher than the band, people expect them to fall. When lower than the band, people expect them to rise.
If interest rates rise, then the price of a bond falls. So if you expect interest
rates to rise, you expect a capital loss from holding bonds.
Liquidity Preference TheoryKeynes’ reasons individuals hold money• transactions motive (positively related to y)• precautionary motive (positively related to y)• speculative motive (negatively related to i)
MD/P = f(i,y)fi = –fy = +
P/MD = 1/f(i,y)Py/MD = y/f(i,y)V = y/f(i,y)
Liquidity Preference Theory
William Baumol and James Tobin showed transactions and precautionary money demand
are also sensitive to the interest rate because people will vary how frequently they visit the
bank based on interest rates.
• average cash balance halves• velocity doubles• gained interest from bonds
Liquidity Preference Theorytransactions demand –
money demand for transactions
Vectors• population: N↑ → y↑ → MD↑ → P↓• output/person: y/N↑ → y↑ → MD↑ → P↓• vertical integration: merge↑ → MD↓ → P↑• clearing system efficiency: eff.↑ → MD↓ → P↑
Liquidity Preference TheoryVectors• population: e.g., black death, baby boom• output/person: e.g., Internet revolution (productivity)• vertical integration: e.g., oil company buys gas stations• clearing system efficiency: e.g., credit card use
Liquidity Preference Theoryportfolio demand –
money demand as a store of value(captures precautionary and speculative)
Vectors• wealth: W↑ → MD↑ → P↓• uncertainty: uncertainty↑ → MD↑ → P↓• interest differential: i↑ → MD↓ → P↑• anticipations about inflation: πe↓ → MD↑ → P↓
Liquidity Preference TheoryVectors• wealth: e.g., win the lottery• uncertainty: e.g., travel to a foreign country• interest differential: i.e., interest rate soars• anticipations about inflation: e.g., print money non-stop
Graphical Version
MD
MS
i
M
Graphical Version
MS↑ → i↓
increasing themoney supply
shifts the MS curve outmove along MD
i goes down
MD
MS
i
M
MS'
i1
i2
Graphical Version
y↑ → MD↑ → i↑
increasing real outputshifts the MD curve out
move along MS
i goes up
i
i1
i2
MD'
MS
M
MD
MD = Py/V
Graphical Version
P↑ → MD↑ → i↑
increasing price levelshifts the MD curve out
move along MS
i goes up
i
i1
i2
MD'
MS
M
MD
MD = Py/V
Modern Quantity TheoryMilton Friedman is a Nobel prize
winning economist from the Chicago school who led the free market fight
against Keynesianism in the 60’s, 70’s, and 80’s. He developed a modern
quantity theory of money based on his permanent income hypothesis and an
expanded asset demand theory.
Modern Quantity TheoryThe permanent income
hypothesis is that people spend money based on perceived
average life income.
The life-cycle hypothesis is one variant: young and old spend more than they earn, middle
age earn more than they spend.
Modern Quantity TheoryMD/P = f(yP, rb – rm, re – rm, πe – rm)
MD/P = demand for real money balancesyP = present discounted value of all future earningsrm = expected return on moneyrb = expected return on bondsre = expected return on equity (stocks)πe = expected inflation rate
MD positively correlated to yP
MD negatively correlated to other terms
Modern Quantity Theory
MD/P = f(yP, rb – rm, re – rm, πe – rm)
Under Friedman’s theory, changesin interest rates have little effect
on the demand for money.Therefore, his money demand
equation can be approximated by:
MD/P = f(yP)
MD/P = f(yP)P/MD = 1/f(yP)
Py/MD = y/f(yP)V = y/f(yP)
Friedman’s velocity isn’t constant, but it is much more stable than Keynes’ velocity because the relationship
between yP and y is very predictable.
VModern Quantity Theory
Empirical Evidence
Empirical evidence shows thatvelocity is not constant.
Velocity is sensitive to interest rates,but is not ultra-sensitive to interest rates
when interest rates are non-zero(i.e., there is no liquidity trap).
V